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Short Butterfly Spreads: Understanding the Basics

Key Points

A short butterfly spread is a breakout strategy—appropriate when you expect a large movement in the underlying security either up or down over the life of the options.

This three-legged strategy involves three different strike prices established in a 1/2/1 ratio.

A short butterfly can be built with either calls or puts.

We look at how you might select strike prices for a short butterfly spread.

A short butterfly is a breakout strategy that has a limited profit zone if the underlying security rises sharply or falls sharply and a limited loss zone if the price of the underlying security ends up between the lowest and highest strike prices.

Short butterflies are typically used when you expect a large move in the underlying security (stock or ETF), but you don’t have a sense of the security’s direction. While they sound complicated (and might even look so pictured on a graph), short butterflies are fairly easy to understand, especially if you are familiar with long butterflies.

A short call (put) butterfly is a three-legged strategy with three different strike prices:

Sell one call (put) at the lowest strike price,

Buy two calls (puts) with a middle strike price

Sell one call (put) with the highest strike price.

The options all have the same expiration date with a middle strike price halfway between the lower and the higher strikes. The position is considered "short" because a net cash credit is received when initiating it. Like many option strategies, the maximum gain, maximum loss, and breakeven points can all be calculated before you enter your order.

When to open a short butterfly trade

The ideal time to enter a short butterfly trade is when you expect a large movement in the underlying instrument (stock or ETF), but don’t have a sense of which way it might move. Typically, the strike prices are chosen when the underlying instrument is trading very near the middle strike price. Let’s take a look at a sample short butterfly trade.

Note that a short butterfly call (put) spread is always established in a 1/2/1 ratio. At Schwab, you'll get a discount on commissions when you enter multi-legged option strategies such as spreads, straddles, butterflies, condors, etc. as a single order, rather than as multiple smaller orders.

When you set up an order like this, StreetSmart Edge® automatically calculates the market price of this 10/20/10 spread. To do so manually, reduce the spread by its greatest common factor of 10 to 1/2/1 and then multiply each leg by the market price, using the ask price on the legs you are buying, and the bid price on the legs you are selling:

The market price of this butterfly spread is a net credit of 1.45, and the total credit would be 1.45 x the number of 1/2/1 spreads (10) x the option multiplier (100) = $1,450.

Below is a chart depicting the profit/loss zones of this example, including the breakeven points, at the option expiration date.

Profit and loss profile for a short butterfly spread

Source: Schwab Center for Financial Research.

The maximum profit on this strategy, which occurs above the highest strike price or below the lowest strike price, is $1,450. Two breakeven points sit at $61.45 and $68.55 while prices between $61.45 and $68.55 result in a loss. The maximum loss at expiration, which occurs only at the middle strike price of exactly $65, is -$3,550.

A look at different expiration price scenarios

To get a better feel for the profit and loss zones, see below for some sample prices at expiration.

How to choose a strike price

A short butterfly spread can be created using either calls or puts, and the general characteristics are very similar regardless of your choice. While a short butterfly is a breakout strategy, you can put a very slight bullish or bearish bias on it, depending upon whether you use above the money (ABTM), around the money (RTM) or below the money (BTM) calls or puts.

Below is a table that may help you decide which strike prices to choose.

Considerations for selecting a strike price

Source: Schwab Center for Financial Research.

Because of the credit received from the sale of the upper and lower strike options, the short butterfly strategy, which provides an opportunity to profit on a stock that is expected to move sharply higher or sharply lower, typically comes at a much lower cost than a long straddle strategy. As a result, when the trade doesn’t work out, the risk is typically lower too.

I hope this article enhanced your understanding of short butterflies. I welcome your feedback—clicking on the thumbs up or thumbs down icons at the bottom of the page will allow you to contribute your thoughts. (If you are logged into Schwab.com, you can include comments in the Editor’s Feedback box.)

Next Steps

Talk to Us
To discuss how this article might affect your investment decisions:
- Call Schwab anytime at 877-338-0192.
- Talk to a Schwab Financial Consultant at your local branch.

Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. With long options, investors may lose 100% of funds invested. Please read the Options Disclosure Document titled Characteristics and Risks of Standardized Options before considering any option transaction.

Multiple-leg options strategies will involve multiple commissions. For the sake of simplicity, the examples in this presentation do not take into consideration commissions and other transaction fees, tax considerations, or margin requirements, which are factors that may significantly affect the economic consequences of strategies displayed. Please contact a tax advisor for the tax implications involved in these strategies.

Spread trading must be done in a margin account. When there is more than one possible way to pair available options in your Account, Schwab has the discretion to determine spread pairings. Schwab may pair options in a manner that does not produce the lowest possible margin requirements.

Supporting documentation for any claims or statistical information is available upon request.

Schwab's StreetSmart Edge and StreetSmart.com are available for qualified Schwab Trading clients only.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

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